Big Trouble in ‘Little’ Italy

Italy’s bond and share markets have fallen heavily since the formation of the populist, Euro sceptic coalition last Friday sent tremors through financial markets.  The coalition brings together the radical anti-establishment Five Star Movement and equally radical anti-immigration Leda Nord to overcome the hung parliament since the March elections.

Despite a bit of ‘buying the dip’ going on last night, Italian bonds remain down heavily.  People too often discount Italy as a hopeless case distraction whilst forgetting its size in the EU equation.  This is not Greece.

Italy is the EU’s 3rd biggest economy but it’s well documented economic struggles and fiscal mismanagement since the GFC have seen it amass the EU’s biggest debt pile, a quarter of all of the EU, and second only to basket case Greece as a percentage of GDP, at a whopping 132% debt to GDP.  Its GDP is still down 8.4% from the pre GFC high, unemployment at 11% and youth unemployment at nearly 32%.

The market’s concerns about the new coalition are twofold.  Firstly the new populist Government has proposed economic policies making no attempt at all to address their debt issue and secondly, whilst avoiding talk of revisiting Italeave (a referendum to leave the EU), it is a clear historic agenda of the key players and lurks as a threat.  The problem with the market’s reaction, which saw bond yields jump over 450 bp’s is that the cost of servicing all that debt goes up putting even more pressure on their budget deficits.  Bloomberg’s macro strategist Mark Cudmore, in an article ominously titled “Italy on Verge of Inducing a Fresh European Crisis” summarised where that leaves things:

“That creates a dilemma for the EU. Either fund Italy’s largesse at the expense of every other member country, or kick Italy out of the euro.

The first option isn’t sustainable. This isn’t a relatively containable problem like Greece. Italy’s economy is almost ten times the size of Greece’s and the third-largest in the euro zone. The PIIGS -- Portugal, Italy, Ireland, Greece and Spain -- were only ever a problem as a group because of concerns that the contagion would infect Italy.

And this isn’t just a sovereign debt problem. Italy’s banks have by far the most non- performing loans in the euro zone, more than a quarter of the total. A section of the plan makes it harder for banks to repossess collateral, further deteriorating the value of those loans.

So while the policy platform doesn’t explicitly state an intention to leave the euro, the new government plan, if instituted as is, makes that the inevitable end-game.

Fortunately, the Italian constitution forbids an excessive budget deficit, so may act as a limiting force. However, the concern is whether they can circumvent those restrictions by selecting favourable economic projections.

The proposal already seems to be stealthily planning for euro departure with a plan to issue short-term debt contracts to pay back arrears. As my colleague Ferdinando Giugliano suggested on Friday, that’s the first step toward a parallel currency.

So Italy’s prospective rulers seem to be fully aware of the end-game and are already planning for it. Investors will soon need to catch up.”